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Lesson Prep

Allocating Capital

From Common Sense Economics: Allocating Capital Given the pace of change and the diversity of entrepreneurial talent, the knowledge required for sound decision-making about the allocation of capital is far beyond the scope of any single leader, industrial planning committee, or government agency. Without a private capital market, there is no mechanism that can be counted on to consistently channel investment funds into wealth-creating projects. Why? When investment funds are allocated by the government, rather than by the market, an entirely different set of factors comes into play. Political influence rather than market returns will determine which projects will be undertaken. Investment projects that reduce rather than create wealth will become far more likely. The experiences of the centrally planned socialist economies during the Soviet era illustrate this point. For four decades (1950–1990), the investment rates in these countries were among the highest in the world. Central planners allocated approximately one-third of the national output into capital investment. Even these high rates of investment, however, did little to improve living standards because political rather than economic considerations determined which projects would be funded. Resources were often wasted on politically impractical projects and high visibility (“prestige”) investments favored by important political leaders. Misdirection of investment and failure to keep up with dynamic change eventually led to the demise of socialism in most of these countries.

Questions:

Think about the latest trendy item – say the newest iPhone. Do you think we would be better off of government officials told Apple how many to make and who to sell them to?

The car in the picture on the left is the latest model of East German Trabant, which cost an average worker eight months’ salary, and to get one, you had to wait six or more years! On the right is one of the latest Corvettes, priced about the same in terms of work ($55,000), but with no wait-time. Which would you rather have? Why do you think the East German planners refused to allow the Trabant to be updated?

This reading is an excerpt from Certell’s Common Sense Economics eBook. Certell offers curriculum materials and eBooks free of charge for students and teachers. Click Here to downloadthe Common Sense Economics Materials.